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Municipal Bond Investments and Marginal Income Tax Rates

Some investors hold municipal bonds in an attempt to reduce their tax burden. This article discusses the relationships between tax-exempt municipal bonds, marginal tax rates, and investment asset tax location.

An investor’s marginal tax rate is important, when making tax-related investment portfolio decisions. By combining your federal, state, and local marginal income tax rates, you can value the “tax shield” that you obtain from an incremental dollar of non-taxable bond investment income versus and incremental dollar of taxable bond income. The higher the combined marginal income tax rate, the higher the potential benefit from investments that yield non-taxable income.

Using 2008 tax rates, here are two examples with married couples filing joint tax returns who are California residents:

Example A — “Couple A” has $100,000 in taxable income after deductions and exemptions, which would put them into the 25% federal marginal income tax bracket and into the 9.55% state marginal income tax bracket, for a combined marginal income tax rate of 34.55%.

Example A — “Couple B” has $250,000 in taxable income after deductions and exemptions, which would put them into the 33% federal marginal income tax bracket and into the 10.55% state marginal income tax bracket, for a combined marginal income tax rate of 43.55%.

For an extra dollar of taxable income, Couple A would pay 34.55 cents in state and federal income taxes, while Couple B would pay 43.55 cents.

Both could avoid these taxes on an extra dollar of income, if they held a tax-exempt bond investment that was not taxed at both the federal and state income tax levels. California municipal bonds could shield them from these taxes and provide such savings. However, the question is whether the tax savings would be sufficient for one or both of these couples to warrant choosing tax exempt municipal bonds versus an alternative investment in taxable government or corporate fixed income bonds.

Because of investor bidding in real-time credit markets, the markets set differential investment yields on taxable versus tax-exempt assets.

The spread between these yields is influenced by bond investor supply and demand on an after-tax basis. Investors in higher marginal tax brackets have a greater incentive to own tax-exempt bonds. Those who benefit the most from tax avoidance tend to gravitate toward tax-exempt bonds and the opposite is true for those who do not.

To compare after-tax yields on taxable and tax-exempt investments, multiply the percentage yield on the taxable bond by one minus the marginal tax rate expressed as a decimal. Then, compare this result with the market yield on the tax-exempt bond. (Obviously, this comparison presumes that otherwise these taxable and tax-exempt bonds have similar maturities, likelihoods of default, and other provisions and characteristics.)

Assuming a taxable bond yield of 7%, Couple A with the combined marginal tax rate of 34.55%, would require that an equivalent tax-exempt bond would yield at least 4.5815% for the tax-exempt bond to be more desirable on an after-tax basis. [(7.0% times (1.0 minus .3455) = 4.5815%)]

Assuming a taxable bond yield of 7%, Couple B with the combined marginal tax rate of 42.3%, would require that an equivalent tax-exempt bond would yield at least 3.9515% for the tax-exempt bond to be more desirable on an after-tax basis. [(7.0% times (1.0 minus .4355) = 3.9515%)]

Clearly, the investor with the highest combined marginal tax rate has a stronger preference for holding tax-exempt municipal bonds. Investors in the highest total federal and state marginal income tax rate brackets get the most benefit, because the after-tax value to them could exceed significantly the actual market yield spread between taxable and tax-exempt bonds.

The lower one’s marginal income tax rates, then the lower ones potential tax shield benefit. At some point, municipal bond yields become disadvantageous for those who have lower marginal income tax rates, when compared to owning taxable fixed income investments. Whether or not to invest in a municipal bond versus taxable bond, of course, depends upon a variety of factors. These include one’s marginal tax rate, the spread at the time, the tax status of the account holding the asset, the concern for potential default, the duration, etc.

This analysis also demonstrates why municipal bonds should never be held in a tax-advantaged retirement account.

With a tax-advantaged retirement account, the current marginal tax rate on both taxable and tax-exempt bonds would be zero. Tax driven bond market supply and demand forces taxable yields upward or tax-exempt yields downward – whichever might be your perspective. Therefore, only taxable bonds should be held in tax-advantaged retirement accounts because of taxable bond yields would tend to be higher than tax-exempt yields on otherwise equivalent bonds.

There is a “sweet spot” for certain investors to hold municipal bonds

Given the factors discussed here regarding marginal income tax rates, bond market taxable versus tax-exempt yield spreads, and the optimal asset location decision between taxable and tax-advantaged accounts, there is a “sweet spot” for certain investors to hold municipal bonds. Those who are more likely to benefit from municipal bonds have the following characteristics.

These investors tend to have an asset allocation that more heavily skewed toward bonds, and they tend to have far more assets in taxable rather than tax-advantaged accounts. Furthermore, they have relatively high current earned income. Investors with this profile, “fill up” their tax-advantaged accounts with taxable bonds. Next, their heavy allocation to fixed income assets then “spills over” into their taxable accounts. In this circumstance, their very high marginal income tax rates might make owning tax-exempt municipal bonds a more advantageous proposition. Nevertheless, an analysis should always be performed using current bond market yields and total marginal tax rates to confirm that tax-exempt municipal bond investments would be more advantageous.

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Roth IRA and Roth 401k Accounts and Roth Estate Planning Strategies

There are trade-offs in deciding how to set the proportion to contribute into Roth retirement savings accounts versus making contributions to traditional retirement accounts with tax deferral advantages. Please use the links at the bottom of this article to read our previous articles on the subject of an optimal Roth retirement account contribution strategy.

In many senses for some people, an optimal Roth retirement account contribution strategy also becomes an estate planning question. In the majority of personal finance situations, making 100% of allowable Roth contributions may not yield the greatest total estate at age 80, 90, or 100, when compared to the opportunity to make currently tax deductible contributions traditional personal IRA and traditional 401k, 403b, KEOGH, and other retirement plan accounts that reduce current taxable income.

However, when you expand your total present value analysis to include the long-term value to a multi-generational family, then Roth assets can have significantly greater value. If Roth assets remain at death, there are very significant long-term multi-generational tax avoidance advantages. In such circumstances where it is likely that a person’s assets will be adequate to cover retirement expenses even with a very long life, then it can be advantageous to live off of traditional retirement plan assets, which are subject to mandatory withdrawals and associated income taxation in retirement anyway. This means that over ones lifespan, when retirement assets are adequate for the long-term, then a larger and increasing proportion of ones future financial asset portfolio could consist of Roth assets.

For estate planning purposes, Roth retirement accounts can have some very significant advantages over traditional tax-advantaged retirement accounts.

If a family’s financial model indicates that there is a strong possibility that they will still have some tax-advantaged account assets at death, then those should be Roth tax-advantaged account assets, when feasible. Roth assets can be inherited by children and other designated beneficiaries, and these inherited Roth assets can also grow tax-free over the expected life of the person inheriting with certain mandatory withdrawal requirements.

For example, this means that a child inheriting from a very elderly senior citizen parent Roth retirement account assets, when that child is age 50, could perhaps enjoy another 40 years of tax-free investment growth with an income stream along the way. Under current law the child would face from mandatory, but non-taxable withdrawals. Only when withdrawn asset have appreciated in taxable accounts, would the fruit of these inherited Roth assets be subject to short-term or long-term capital gains taxes. Traditional tax-advantaged retirement accounts do not provide these very significant and valuable estate planning benefits.

You should note that the rules regarding Roth retirement plan accounts are in flux.

It is not clear what they might be over the course of your life. However, income limitations have changed and traditional to Roth asset conversions seem to be possible without income restrictions during 2010. These year-to-year changes are the reason why it makes a lot of sense to download from the IRS website and read the relevant US income tax publications, including IRS Publication 560 and IRS Publication 590. Again, consulting a knowledgeable certified public accountant may help you with current rules strategy.

Furthermore, you should also use the top retirement investment planning calculator to better understand the potential size of your projected Roth retirement nest egg assets in the future. You should find out whether you could be one of the minority of the US taxpaying population that could mass significant Roth retirement account assets and be able to pass them to your heirs with the associated tax advantages to your beneficiaries.

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Deciding between traditional retirement plan contributions and Roth retirement plan contributions

Whether or not to make investments into “traditional” tax-advantaged employer accounts and IRAs versus investing in “Roth” tax-advantaged employer accounts and personal IRAs is not always a straightforward decision. The decision on the trade offs happens to be one of the most complex aspects of lifetime personal financial planning.

A broad array of factors can influence whether a traditional retirement plan account contribution or a Roth retirement account contribution decision would be optimal. Given the significant importance of this decision on your lifetime financial plan and the build-up of your retirement savings, it would be worth taking a closer look at this decision. For most people’s lifetime circumstances, making deposits in traditional accounts is the preferred decision, when those contributions would be deductible against current income taxes.

Factors favoring Roth plan contributions over traditional plan contributions

Many people struggle with the traditional versus Roth contribution decision for their personal financial and investment planning. The trade-offs over a lifetime are very complex. Rules-of-thumb, back-of-the-envelope calculations, and simple retirement planning spreadsheets cannot model all the important personal financial factors.

The decision is not simply about present versus future tax rates and whether rates might be higher or lower. Instead, the decision requires a personalized and comprehensive projection and valuation of an investor’s lifetime income, expenses, debts, net assets, and taxes. (Look here for a sophisticated Roth IRA and Roth 401k calculator tool that fully automates the traditional versus Roth analysis.)

Also, be clear in noting that this discussion focuses ONLY on situations where an investor has the choice of making a CURRENTLY TAX-DEDUCTIBLE traditional IRA, 401k, etc. contribution VERSUS a CURRENTLY NON-TAX DEDUCTIBLE Roth IRA, 401k, etc. contribution. For most people, this is often they case, because they have not maxed-out their current opportunities to make tax-deductible traditional retirement plan account contributions.

If under the U.S.’s incredibly complex tax-advantaged retirement account rules, an investor does NOT have any further opportunities to make currently tax-deductible retirement account contributions, then a Roth contribution is the choice to make. Since an investor cannot take a current tax-deduction and since Roth account contributions avoid future taxation of asset appreciation in retirement, that is why such Roth contribution would be preferred over traditional retirement account contributions, under these limited circumstances of non-deductibility.

Whether or not a person or family will save enough and invest efficiently across a lifetime dominates the Roth retirement plan versus currently deductible traditional retirement plan contribution decision.

If an investor does not earn sufficiently high income, does not save aggressively, does not control investment costs, and/or does not grow a sufficiently substantial investment asset portfolio retirement nest egg, then that investor will not have to worry about being in high tax brackets in retirement — whether or not state and federal income tax brackets had moved up or down in the interim. If an investor will not have substantial assets and income in retirement, then the current tax savings an investor could get from contributing to a traditional tax-advantaged retirement savings plan will tend to be much more economically advantageous over a lifetime.

For an investor to justify making current Roth contributions in lieu of currently deductible “traditional” contributions, here are eight personal circumstances, taken together, that might reverse the average person’s preference for traditional tax-advantaged plan contributions.

Roth retirement plan contributions might be more advantageous over currently deductible traditional retirement plan contributions, when a retirement investor:

1. has a long time for her assets to appreciate before and during retirement.
2. is likely to earn high enough taxable income over her working lifetime to have a realistic chance of amassing enough assets to cover her retirement expenses easily and still build up financial assets.
3. is more likely to have increasing earned income that is expected to continue to rise in real dollar terms across a working life cycle, enhancing that investor’s ability to feed her investment program through increasing savings.
4. saves at sufficiently high percentage rates across her working lifetime. (This means consistently saving at rates that are well in excess of 10% of gross earned income.)
5. will fully fund either traditional and/or Roth tax-advantaged accounts up to maximum annual contribution limits.
6. may have proportionately higher front-loaded itemized deductions (e.g. mortgage interest and real estate taxes) and lower earned income that effectively lowers an investor’s nearer term federal, state, and local marginal ordinary income tax rates compared to her more distant retirement years.
7. will adopt a very low-cost investment strategy to improve her chances of capturing higher asset appreciation rates.
8. will maintain an investment asset allocation that is skewed heavily toward equities, and when her financial assets continue to grow at rates that are similar to long-term historical rates of return on equities.

Given all these factors, an investor may find that her assets in traditional tax-advantaged accounts would grow to be so substantial that when they are distributed under the mandatory distribution rules after age 70 and 1/2, she is pushed into much higher marginal tax brackets. If her traditional tax-deferred assets are sufficiently large, then ordinary income taxes on these mandatory distributions COULD wipe out the value of the tax shield assets that an investor gained by making traditional account contributions that reduced her taxable earned income in earlier years. This is the crossover point where Roth contributions become more desirable on a present value basis compared with currently deductible traditional retirement new investments. Again, the majority of those saving for retirement are less likely to be in this position and should therefore prefer reducing their currently taxable income through traditional retirement plan contributions.

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